We are living in an era where generating income is not an easy task. Investors everywhere are struggling to squeeze a little more return out of their portfolios.
Combine this objective with a desire to reduce volatility and it’s no wonder that more and more discussion focuses on Covered Calls. The objective of this article is threefold:
- Discuss the mechanics of covered calls
- Discuss their latent shortcomings
- Offer a more practical alternative
I’m going to avoid highly technical and fully intricate explanations in order to accomplish these objectives without writing an article the size of a book.
I’ll try to keep it in the vernacular and deal more with concept than detail. In so doing, this article will represent a starting point for considered research by the investor. It is my hope that the reader will appreciate the nuance in covered calls.
Mechanics of Covered Call Options
A covered call is the process of writing (selling) a call against a particular underlying security. In exchange for selling the call, the investor receives a premium credit. Many view this as “additional income” when it really is just an exchange for any appreciation in the underlying stock that is above the strike price. It slowly converts to income as time passes and if the underlying remains below the strike. However, if the underlying climbs above the strike it slowly converts to an expense.
The call could be sold at various strikes and various expirations. The further out-of-the-money (OTM) the less premium received. The farther away the expiration the greater the premium credit received. There are literally hundreds upon hundreds of combinations. The first challenge an investor has is to determine which of those strikes and expiries is most efficient.
The optimal strike would be the strike that receives the maximum premium while giving up the least amount of growth. For instance, if the underlying stock was trading at $100 and grows to $105, the optimal strike would have been $105. If the strike was below that, say at $102, one would have received slightly more premium, but given up $3 in appreciation.
Of course it’s impossible to know in advance where the underlying will land at expiry, so this requires some skill and luck. Otherwise, the “additional income” can be completely offset by “loss of appreciation” or poor overall performance.
An additional consideration – and one understood by most experts – is that covered calls effectively change the dynamics of the underlying stock. Inasmuch as the call puts a “cap” on price appreciation in return for premium credit, it has the effect of moving a growth stock closer to a value stock and a value stock closer to an income stock.
So the first question I would ask any investor that was considering writing a covered call on a TESLA or AMAZON or any growth stock is this …
“If you cap the growth in exchange for income, why not just sell the growth stock and buy a value or income stock, instead?”
I do need to add that since the covered call lowers the risk profile of the underlying in exchange for growth, it also has the effect of reducing the volatility or Beta of the stock. This is because the premium credit helps in a decline. When you have less potential downside and less upside you have less volatility.
Shortcomings of Covered Call Options
Most people think of the shortcomings of covered calls as the possibility that the underlying will rise up rapidly and the stock will be “called away” with loss of appreciation.
I don’t consider that a shortcoming. It was part of the bargain. It was a calculated risk. When one takes a calculated risk and it doesn’t work, the shortcoming is not in the risk, but in the one making the calculation. If one drives recklessly and gets into an accident, it is not a shortcoming of the vehicle; it is a shortcoming of the driver.
There is a real shortcomings to covered calls. But it takes a little explaining. Here goes ….
Let’s say one has a portfolio of twenty positions and wants to increase yield via covered calls. They really can’t pick just one or two stocks; the effect would be minimal.
What procedure would one follow in picking just a few of their positions? If ABC is a candidate because it has less potential than XYZ, why not just sell ABC and buy XYZ?
One would never employ a covered call on a stock they favor, only stocks they don’t favor. So, is the process of choosing, itself, an indication that a portfolio overhaul may be more appropriate than a covered call?
For an investor to make a noticeable impact on their portfolio they would need to write covered calls on large portions of their portfolio. Only then would the cumulative premiums be significant and provide a reasonable level of “additional income”.
There is a concomitant increase in the effort to administer multiple positions. Not only are the costs increased but the likelihood of error becomes greater. Also, options are offered in 100 share equivalent lots. So, only round lots can be precisely “covered”.
Here’s The Real Problem with Covered Call Options
Lets’ say the overall portfolio grows in a particular month by 1%. Let’s also say the investor correctly predicted the 1% growth and wrote covered calls on every position 1% OTM.
Perfect… Or is it…
Portfolios that grow 1% are made up of positions that increased more than 1% and positions that increased less than 1% (or even decreased).
There may even have been a position that increased 3% and another that lost 1%. The average return of the two positions is 1% ((3%-1%)/2).
However, since there were covered calls, every position that increased more than 1%was capped and that “excess growth” was not realized.
On the other hand, the positions that increased less than 1% or lost remain. So, instead of the normal characteristics of the portfolio … winners and losers above/below 1% … the portfolio had no winners above 1%. The portfolio would have returned 1%, but after giving back the “excess growth” on some positions it actually underperformed itself.
The situation is even worse if the entire portfolio increased by more than the 1% covered call strike. What if it went up 2%.
Well, every position that increased more than 1% (and there must be many) is “chopped off” at 1% and every position that increased less than 1% remains intact. So, it is possible that the net return on the portfolio ends up less than 1%, when, without the covered calls it would have been 2%.
Even if the portfolio incurred a net loss, say 1%, there may well be stocks that increased and maybe even more than 1%. The same problem exists, just less severe.
Now, if anyone is so gifted as to be able to choose strikes and expiries on twenty positions where they sell each call at exactly the right strike to maximize premium credits and never get a strike over-run… Please, please contact me… I’d like to know what you’re doing.
Another shortcoming of covered calls is that many investors have positions in mutual funds and no one writes covered calls against mutual funds. This is not to be confused with mutual funds that get on the covered call bandwagon and write covered calls on their own portfolio.
Lastly, the biggest shortcoming of all: Option probabilities and pricing.
Options are very similar to a casino. The market makers have very sophisticated tools and methodologies that all but guarantee that they make money. Some investors will make money and some will lose money. Overall, the option-investing public loses money.
That means, when one looks at the premium credit received and the strike corresponding to it, the premium credit reflects the probability that the strike will be over-run. Sell an option once or twice and you may win. The more often you sell, the laws of large numbers come into play and it is a zero sum (less trading costs) game. There is no free lunch.
Let me be clear about one thing. It is very possible that after accounting for “heads being chopped off”, the portfolio is still ahead as a result of premium credits received from the covered calls. In order for this to occur on a medium or long term basis this means overcoming at least:
- Strike and expiry selection for multiple positions
- Trading costs and time demands
- “Over-runs” and “Under-runs”
- Probability component in pricing
Hopefully one can see that covered calls present some real problems. On paper they sound appealing … in reality they are problematic. There is one method that can alleviate most of these problems and it is the method that serious investors use instead of covered calls.
Before I proceed, some investor “introspection” is necessary. Each investor has assembled a portfolio of equity investments.Maybe they are individual stocks, mutual funds, ETFs, etc. or some combination. Each investor must assume that their portfolio of equities will outperform some benchmark, most typically the S&P 500. If the investor doesn’t believe that they can outperform the benchmark, then they should just scrap their portfolio and buy an ETF that IS the benchmark. There are certainly enough to choose from.
I fully realize that this sounds a little trite but it is fundamental. Either one believes they can outperform the benchmark or they should invest in the benchmark. So, for purposes of this article, let’s assume that the investor has a diversified portfolio and they benchmark it to the S&P 500.
Well, it couldn’t be simpler. Instead of covered calls, use a call-write strategy (naked calls) on the S&P 500. This can be done by selling naked calls on the SPY ETF or the SPX index. Let’s look at the advantages.
Advantage #1: Only requires one transaction. The investor picks the portfolio value they want to write a call against and computes the appropriate number of options. For instance, let’s say one has a portfolio of $200,000. They want to write calls against only around $160,000 of their position. If they used the SPY ETF, setting a strike at, say $210, they just enter one trade for 8 options. Each option represents 100 shares, so the math is:
8 x 100 x $210 = $168,000. Close enough.
Advantage #2: No “winner” is called away. One gets the full results of their portfolio. Let’s say the naked call on SPY was 1% OTM and their portfolio goes up 1.2%, while the SPY goes up 1%. The portfolio keeps the “extra” .2%. This is also true if the portfolio grows 2% and SPY ETF only 1.8%. Though there is money lost on the SPY over-run, it is less than the portfolio gains.
Advantage #3: Choose what to sell. Using covered calls, any stock that over-runs the strike can be called away and sold. If one wanted to hold onto these “winners” they would need to buy them at a price higher than they were sold. Sell low; buy high is not good procedure. Using a call-write benchmark, say SPY ETF, over-runs the strike. The investor can choose to meet this over-run by selling selected securities or cash.
Advantage #4: Trading Costs. Naturally the trading costs are less for one trade than 20. But also the bid/ask spread if using SPY can be much lower than individual stocks. As much as 5%-10% lower.
Issues to Resolve
Issue #1: Covered calls are permitted in IRAs and ROTHs, but NAKED calls are not. There is a work-around. Given proper trading authority, one can sell call spreads in an IRA or ROTH. Let’s say one wanted to sell a naked SPY call at a strike of $210. Though that is not permissible, one could sell the call at a strike of $210 and buy a call at a much higher strike. A strike that would only cost, say 1cent. A monthly call at around $225 would fit that parameter. So instead of naked at $210, it would be a credit spread at $210/$225. Instead of a naked call credit of 56cents, it would be just 55cents credit. Though this is a cost, it is more than offset by the benefits over selling covered calls.
One must also do some serious monitoring of the position when using SPY options. If there is an over-run, SPY can be assigned as a short position. IRAs and ROTHs may not hold short positions so one would need to close out the short ASAP. However, for most everyone it will create a trading violation. To avoid assignment issues, one should consider using cash-settled options … index options such SPX or XPS (mini SPX). Cash settled index options, as opposed to ETF options, just debit/credit your account at expiry.
Issue #2: The second issue is tax considerations. Net gains/losses from selling calls on stocks or ETFs are ordinary income. While this is not an issue in IRAs and ROTHs, it is a concern in taxable accounts. To the extent there are gains in taxable accounts, they will be taxed at the higher ordinary rate rather than the lower capital gains. There is a partial work-around for this. Taxable accounts should write calls utilizing index options, such as SPX, XPS, RUT, etc. These are considered 1256 contracts and net gains/losses are automatically 60% Long Term Capital Gain and 40% Short Term capital gains, regardless of holding period. One must be a little more diligent on entering limit versus market orders but the tax benefits are substantial.
What if your portfolio is made up of index funds? Many investors have already chosen ETFs instead of individual stocks – like these high quality dividend ETFs. In these situations the covered call is the benchmark. Congratulations, you’ve made it easy for yourself. Just write covered calls.
I would only suggest that those in taxable accounts consider using index calls instead of covered calls to take advantage of 1256 favorable taxation.
This article was written with the intent to illustrate some practical problems with covered call strategies. They can be effective on a pick and choose basis, but that requires some mastery. If one wants to have a measurable impact on an entire portfolio, covered calls are more likely to represent a drag on performance than “additional income”.
However, with a little creativity and some practice, the drag can be eliminated and the investor can easily administer a call-write benchmark strategy on all or portions of their portfolio.
Before one engages in a call-write benchmark strategy they should do some serious introspection. The fundamental component of benchmarking is the ability to create a portfolio that will outperform the benchmark.
If the individual investor actually underperforms the benchmark they will suffer. Not only on the underperformance, but by any strike over-runs the benchmark encounters that are not equalized by the individual portfolio. The last thing anyone wants to encounter is a situation where something else not only did better, but your own returns were reduced on account of that external outperformance.